Blockchain Learning, Proof of Stake

Terra’s Approach to Decentralization

By Connor Smith

Note: This is the fifth installment of a series detailing different approaches that blockchain networks have taken to decentralize their network. Part 1 introduced the concept of decentralization and the inter-play it has with certain aspects of crypto networks like governance, incentives, and network architecture. If you missed that article I highly recommend going back and reading it here. The subsequent articles have been examinations of the decentralization on Bitcoin, Factom, & Cosmos. If you missed those and would like to go back and read them before we dive into Terra, you may do so, here, here, & here respectively.

Hey everybody, and welcome back! Last week, we dove into our first proof-of-stake network, Cosmos, and analyzed how it has approached decentralization in its quest to build the ‘Internet of Blockchains’. In addition to assessing how decentralization has worked thus far on Cosmos, we also got into the nuts and bolts of how the underlying technologies supporting its ecosystem of interconnected, application specific blockchains (Tendermint BFT, ABCI, & IBC) work, and the modular network design of Cosmos with hubs and zones. This week, I will be picking up right where we left off and analyzing one of the networks building on top of Cosmos that is seeing major real world use and adoption, Terra

Terra aims to provide a price stable cryptocurrency, built on top of the Cosmos SDK, that will function as the infrastructure layer for decentralized financial applications. The protocol utilizes an elastic monetary supply that allows for both a stable price and the censorship resistant capabilities of Bitcoin to be maintained, enabling it to be used in everyday transactions. Currently, Terra is the backend technology powering CHAI, a mobile payments application that allows users to link their bank accounts and participate in ecommerce using Terra’s currency and receiving discounts in exchange. 

Terra is currently backed by South Korean internet giant Kakao and integrated with over 10 e-commerce platforms in Southeast Asia. The platform has seen rapid growth since launching last April, having just reached over 1,000,000 users last week, and continues to grow. With so many cryptocurrencies struggling to break into the commercial sector and seemingly every new year being the year we will finally start to see adoption, this is certainly no trivial feet. So now, without further ado, let’s dive into Terra and see how this network has approached decentralization on their quest to become the largest payments platform in Asia!

So What is Terra and How Does it Work?

Before we dive into the technical underpinning of Terra, the problem it solves, and its approach to doing so, it will help to first have some context regarding the rather unconventional background of its founders and some of the history leading up to its launch. Work on the project commenced in April of 2018, led by co-founders Daniel Shin and Do Kwon. Kwon had previously worked as a software engineer at Apple and Microsoft, in addition to being founder and CEO of a startup called Anyfi that attempted to use peer-to-peer mesh networks to try and create a new, decentralized internet. Shin was a successful serial entrepreneur, having built and sold multiple e-commerce companies in East Asia, and, at the time, was CEO of his most recent startup, TicketMonster, the leading e-commerce platform in Korea. Leveraging their extensive backgrounds in e-commerce and distributed systems, the pair sought to create a modern financial system built on-top of a blockchain that could be used by people to make everyday payments. The two believed that the major roadblocks to adopting cryptocurrencies largely stemmed from the extreme price volatility and lack of a clear path to adoption that most networks exhibited. Thus, they designed Terra to be a price-stable, growth-driven cryptocurrency that was focused on real world adoption from day one. Leveraging Shin’s deep connections in e-commerce, they formed a consortium of e-commerce companies known as the Terra Alliance. Within a few months of launching, 15 Asian e-commerce platforms had joined that represented a total of $25 Billion in annual transaction volume and 40 million customers. This coincided with a $32 million seed round investment the team raised from some of the world’s largest crypto exchanges and top crypto investment firms. Having a war-chest of funding in place and real world partnerships aligned, the team was off to the races as they started building the project and integrating it with e-commerce platforms.

Seeing as Bitcoin launched over a decade ago as a peer-to-peer electronic cash system, you may be wondering why a protocol like Terra was still tackling the issue of digital payments. This is largely because Bitcoin and other cryptocurrencies exhibit significant price volatility, making consumers nervous whether it will maintain its value when they try to transact with it later. For perspective, Crypto markets can fluctuate 10% or more in either direction on any given day, and in late 2017 Bitcoin was trading at nearly $20,000/BTC and less than two months later was trading between $6000 – $9000 (at the time of writing this article Bitcoin is trading at $8415.65). Terra, was far from being the first or only project to realize that price volatility posed a significant barrier to crypto adoption. Attempts at creating a price-stable cryptocurrency, or stablecoin, date back as far 2014 with BitShares, and have proliferated at a momentous rate in the wake of the volatility exhibited in the last crypto bull market in late 2017. 

Stablecoins are exactly what their name suggests, a cryptocurrency designed to be highly price-stable in respect to some reference point or asset and maintain the following three functions of money: a store of value, a unit of account, and a medium of exchange. While this sounds fairly intuitive and straightforward, the engineering behind these instruments is quite difficult with no agreed upon approach. Cornell University attempted to codify the different approaches some networks are taking, and put forth a paper classifying the different design frameworks for stablecoins, which can be found here. The finer nuances and mechanics of each approach exceed the scope of this article, but the study revealed that most stablecoins maintain price using one of the following mechanisms: a reserve of pegged/collateralized coins or assets, a dual coin design, or algorithmically. 

Maintaining a reserve of a pegged or collateralized asset allows the organization controlling the stablecoin to maintain price by incentivizing users to expand or contract the supply until it returns to its pegged price. Users are able to earn money by expanding the supply when the price is high and redeeming when it is low through arbitrage until the opportunity disappears and the price has equilibrated. The dual coin approach is where a network implements a two token system in which one coin is designed to absorb the volatility of the first through a process known as seigniorage. This is where the secondary coin is auctioned in exchange for the stable coin if it dips below the peg and the proceeds are burned to contract the supply and stabilize the price. Conversely, if the price of the stablecoin is above that of the peg, new coins will be minted to those holding the secondary coin to expand the supply and level the price. Lastly, the algorithmic approach uses complex algorithms and quantitative financial techniques to adjust the currency price as needed without any backing of pegged or collateralized assets. Hence, it behaves analogously to a traditional cryptocurrency in the sense that a user’s balance and outstanding payments vary proportionately with changes in the market cap of the coin, but it provides a more stable unit of account. 

Terra utilizes a dual coin approach in which the transactional currency, Terra, represents an ecosystem of cryptocurrencies pegged to real currencies like USD, EUR, KRW and the IMF SDR, and Luna is the secondary coin that absorbs the volatility.  All of the Terra sub-currencies (TerraKRW, TerraUSD, etc.) can be swapped between one another instantly at the effective exchange rate for that currency pair, allowing the network to maintain high liquidity. Since the prices of these fiat currencies are unknown to the blockchain natively, a network of decentralized price oracles are used to approximate the true value of the exchange. Oracles, in this context, are essentially trusted data sources that broadcast pricing data generated from currency exchanges onto the network. They vote on what they believe the true price of the fiat currencies to be, and, so long as they are within one standard deviation of the true price, are rewarded in some amount of Terra for their service. Should the price of Terra deviate from its peg, the money supply is contracted or expanded as needed using a seigniorage method similar to that described above. Hence, oracles mining Terra transactions absorb the short Term costs of contracting the supply and gain from increased mining rewards in the mid to long term. 

Luna and the Critical Role is has in the Tokenomics & Governance of Terra

However, since Terra is a proof-of-stake network, oracles must have stake in the network in order to be able to mine Terra transactions. This is where the second token, Luna, comes in. Luna is the native currency of the protocol that represents the mining power of the network, and what miners stake in order to be elected to produce blocks. Luna also plays a critical role in defending against Terra price fluctuations by allowing the system to make the price for Terra by agreeing to be a counterparty for anyone looking to swap Terra and Luna at the exchange rate. In other words, if the price of TerraSDR << 1 SDR, arbitrageurs can send 1 TerraSDR to the system for 1 Luna and vice versa. Thus, miners can benefit financially from risk-free arbitrage opportunities and the network is able to maintain an equilibrium around the target exchange rate of Terra irrespective of market conditions. Luna is also minted to match offers for Terra, allowing for any volatility in the price of Terra to be absorbed from Terra into the Luna supply. In addition to the transaction fees validators collect from producing blocks, the network also will automatically scale seigniorage by burning Luna as demand for Terra increases. As Luna is burned, mining power becomes scarcer and the price of Luna should theoretically increase. This scales with the transaction volume and demand on the network, allowing miners to earn predictable rewards in all economic conditions.

In the most recent update for the protocol (Columbus-3) on December 13, 2019, Luna gained even more utility in the Terra ecosystem by allowing its holders to participate in on-chain governance. Luna holders can now submit proposals for parameter or monetary policy changes to the network as well as make general text proposals and request funds from the community pool (a portion of the seigniorage tokens available to fund community initiatives). If a proposal receives a super majority of supporting votes, the proposal will be ratified and changes made. Not only does this extend to the functionality of Luna, but it also opens up the user base of individuals who can actively participate in the network. Before the Columbus-3 update, Luna only added value to miners on the network, but now anyone can purchase Luna and use it to participate in governance. Moreover, Luna transactions are tax free so it is even easier for non-miners to acquire to participate on the network. 

Terra also has a governmental body known as the Treasury that is designed to allocate resources from seigniorage to decentralized applications (dApps) being built on top of the platform. After registering as an entity on the Terra Network, a dApp can make a proposal to the Treasury for funding, and Luna Validators may then then vote on whether to accept or reject the application based on its economic activity and use of funding. Should the application receive more than ⅓   of the of the total available Luna validating power, it will be accepted and the Treasury will allow the dApp to open an account and receive funding based on the proportional vote it received from Luna validators. The Treasury ultimately determines how funds are allocated to dApps, but, if the community feels the firm is not delivering results, validators can vote to blacklist the dApp. Ultimately, this tiered governance structure is designed to provide Luna holders with a way to determine what proposals and organizations receive funding based on the highest net impact it will have on the Terra economy.

So How Decentralized is Terra?

As of writing this article, there are currently 61 validators located around the world on the Terra Columbus 3 mainnet (We at Consensus Networks are on this list and have been active validators since Terra first launched this past April!). While only about ⅓ of the size of the number of validators on its parent network, Cosmos, this is still a fairly impressive degree of physical decentralization when considering Terra underwent a fully decentralized launch and has been concentrating on integrating with e-commerce platforms exclusively in Southeast Asia. However, as of the writing of this article, the top 9 validators control 62.8% of the voting power on the network. So, similar to what was observed last week with Cosmos, a very small handful of network participants control the majority of economic and governance resources.

However, what is less clear, is if this centralization of resources has as significant of consequences on a growth focused stablecoin network like Terra. For example, Seoul National University’s blockchain research group, Decipher, conducted an in depth study on Terra that concluded it exhibits much greater price stability than other popular stablecoins like USDC or USDT. Terra has also on-boarded 14 online e-commerce platforms and over 1,000,000 users onto its payments application, CHAI, resulting in over $130 million being processed by the network to date. They have also begun expanding outside of South Korea into areas like Mongolia and Singapore. Given that Terra’s mission was to be a price-stable cryptocurrency with a clear path to market, it objectively appears that they have been successful in their goal thus far (Especially when considering that the mainnet has been live for less than a year). With validators receiving rewards in two forms (transaction fees and Luna burn), Terra has created a rewards structure that is predictable under all economic conditions for validators, giving them little to gain from colluding in an attempt to undermine the network. 

Yet, the recent additions of on-chain governance in Columbus-3, Luna being listed on more exchanges, and Luna receiving a tax exempt status on transactions introduces new layers of complexity to the Terra ecosystem that could pose a threat to the decentralization of the network. Now, anyone can vote on proposals that affect Terra’s  future trajectory at both a governance and functional level. When considering that proposals on the network require a supermajority of votes to pass, the threat of collusion between a handful of parties controlling most of the resources now poses a much greater threat. For example, if the top 9 validators were to collude and try to pass a proposal that benefited them at the expense of the network, they would only need to acquire roughly 4% more of the voting power to reach the supermajority needed approve it and change the protocol at a functional level. Additionally, given Terra’s adoption-driven growth model, there are now a whole new range of stakeholders that must be factored into the ecosystem like e-commerce platforms and users of Terra-based applications. While still unclear how this will evolve over time, effectively anticipating and designing for these new dynamics is one of the primary focus areas of the team moving forward, as can be seen here

Given the major shifts in how the protocol operates and the massive influx of new stakeholders, it is far too early to speculate on how Terra’s approach to decentralization will proliferate into the future. Regardless, the fact remains that Terra’s adoption-driven approach to growth has made it one of the few cryptocurrencies that has started seeing demonstrable real world use to date. Having recently hired Uber’s former Head of Strategy, Rahul Abrol, to spearhead their international growth efforts, Terra and CHAI has a very realistic chance of achieving their goal of becoming the leading payments platform in Asia in the years to come. Thank you for reading, and I hope you enjoyed the article! Tune in next week as we explore the other massive project looking to create the internet of blockchains, Polkadot, and its Canary Network, Kusama